Could climate change cause the next financial crash?

The impacts of the global financial crash are still being felt around the world. But even as fragile economies are barely beginning their slow stutter towards growth, we may be heading towards the next major shock to our financial markets. The cause of the next crisis, however, is unlikely to be high-stakes casino banking. Instead, it could stem from financial markets’ failure to sufficiently account for the risks posed by climate change.

According to a new report, “Financing Climate Change: Carbon Risk in the Banking Sector”, by Boston Common Asset Management, investors may unwittingly be investing vast sums in financial institutions that will be adversely impacted by the effects of climate change. The report warns that the banking industry has not successfully integrated climate risk into its long-term strategic planning.

Groups such as Ceres’ ‘Investor Network on Climate Risk‘, have been working hard to demonstrate the risks that climate change poses to financial markets. However, the Boston Common Asset Management report warns that a fundamental lack of appreciation or understanding of the game-changing implications of climate change remains pervasive in the banking industry.

Geeta Aiyer, president of Boston Common Asset Management, maintains that the banking industry is vulnerable to climate change in ways that many other sectors are not. “Banks are connected to every market sector, making them uniquely vulnerable to the economic and political uncertainty caused by climate change,” she said.

Climate change will affect each market sector in different ways. The adaptation challenge for any one sector will be complex. The fact that the banking sector is connected to all of these sectors leaves it exposed to the full spectrum of climate risk.

Exposure to such a wide range of different climate risks should be of real concern for the industry, however, it also offers opportunities to increase resilience. This is because the flip side of being connected to a wide range of sectors is that it allows banks to spread their climate risk. In order to do this effectively, investors must have a good understanding of the nature and level of climate risk across their portfolios.

Transparency, long-term planning and risk management.

So what needs to happen to ensure that financial markets are resilient to climate risk? There is a pressing need for banks to take account of the multifarious climate risks that affect them. One problem in this regard is a lack of transparency for investors. “Since banks are not required to disclose climate risks, investors simply cannot see the potential risks buried in their portfolios,” explains Aiyer.

A legal requirement forcing banks to report on their climate risks as part of their normal accounting procedures would allow investors and shareholders to put pressure on institutions to change their investment strategies.

For their part it is important that investors identify which banks are taking early action to understand and account for their exposure to climate risks. Banks that have strategic management plans in place to address climate change risk and take advantage of new market opportunities will be best able to cope climate-driven volatility.

Firstly banks should integrate climate risk into their standard risk management processes. In this regard, the report specifically recommends that banks conduct regular stress tests that model the effects of adverse climate events and rebalance portfolios to account for climate risk exposure.

Secondly, banks must understand climate change not just in terms of risks, but also consider the enormous opportunities that it will present. Banks are in a position to drive financial innovation and invest in new products and services that will emerge in a world with a warming climate.

Finally, banks will need to develop a long-term climate strategy. The report calls for banks to “move beyond anecdotes about individual funded projects” and instead provide company-wide assessments of the implications of climate change.

Redefining good performance

A successful transition to a climate resilient financial system will require a shift in attitude from shareholders, investors and banks. Quarterly financial reporting cycles put pressure on companies to deliver continuous growth in profits, but do little to encourage long-term strategic decision-making.

Routinely reporting on financial performance and the prominence that this receives in the media inevitably means that decisions are weighted heavily to ensure short-term growth. Company performance, in the banking sector and beyond, should be judged using a much broader set of indicators that account for social, climate and other environmental factors.

Governments and financial institutions around the world are working hard to ensure that the kind of structural risks that caused the recent financial crash are greatly reduced. However, their efforts will amount to little if external risks to the financial system are not addressed. Climate change could be the mother of all external risks.

A copy of the “Financing Climate Change: Carbon Risk in the Banking Sector” can be downloaded here.

This article first appeared on the Acclimatise News Network. It has been republished here with permission. To view the article in its natural habitat click here.